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Real estate securitization.

As real estate values continue to deteriorate and liquidity evaporates, the crisis at thrift institutions, banks, and insurance companies worsens. The current magnitude of commercial real estate loan exposure and the trend toward continued increases in loan delinquency rates mean that traditional financing will become even more difficult to obtain. There is an unquestioned need for creative products to provide nontraditional sources of financing. Wall Street is actively interested in supplying this capital. The securitization of real estate has given institutions a much needed alternative source of capital while providing investors with a rate of return commensurate with the risks.

Headlines about the real estate crisis have become commonplace. The current market has been variously characterized as slow, restrictive, overbuilt, overvalued, and even underdemolished. As real estate values continue to deteriorate and liquidity evaporates, the crisis at thrift institutions, banks, and insurance companies worsens. The current magnitude of commercial real estate loan exposure and the trend toward increases in loan delinquency rates mean that traditional financing from banks will be even more difficult to obtain, and thus can rarely be relied on to meet current real estate financing needs.


The status of conventional lenders is summarized in the following section.

Commercial banks

Commercial banks hold about $350 billion in commercial real estate loans and are subject to intense pressure from regualtors to limit their exposure from real estate investments. Further, the stock market punishes publicly traded institutions encumbered with large real estate holdings. This category of lenders is virtually out of the market. When real estate loans are made, additional guarantees are increasingly common.

Life insurance companies

Life insurance companies hold approximately 25% of all commercial mortgages in the United States, aggregating over $200 billion. About half of the amount they will invest this year is derived from maturing mortgages that cannot or will not be refinanced. This allocation will increase over the next few years as approximately $90 billion worth of mortgages mature prior to 1994. Mortgage delinquencies and foreclosures hit record highs in 1991--5.5% of the total dollar amount of mortgage loans outstanding in the second quarter of 1991 compared with 3.7% at the end of 1990--following a decade of stabilization at less than 3%.

Pension funds

In the near term, pension funds will not increase their real estate allocations. Any increase in investment activity will most likely be a result of increasing fund size rather than increased allotments. Pension funds are logical investors because of their extended time horizons; long-term real estate financing matches their long-term actuarial liabilities. Funds are approaching the market cautiously, however, because of the poor performance of real estate in general over the past five years. Further, real estate suffers a credibility gap with some fund advisors. In light of their experiences, pension funds' hurdle rate for investing in real estate has increased.

Foreign investors

Foreign investors are having their own problems at home. Office vacancies in London are now almost as high as they are in Manhattan--approaching 20%. The Ministry of Finance in Japan has placed increasing pressure on banks not to lend on U.S. real estate. Also having an effect is the adverse publicity associated with owning U.S. "trophy" assets such as Rockefeller Center in New York City. Many foreign institutions have become proactive, selling their holdings or foreclosing on borrowers to protect their mortgages, which now frequently exceed the prices the properties can command in the current depressed economic environment.

While the depressed economy has made traditional sources of real estate financing scarce, Wall Street has taken an active role in developing new approaches to meet this financing need. Institutions have turned to the securities market as a means of raising capital, capitalizing on strong investor demand for new issues. Securitization of commercial real estate, originally developed in the late 1980s, is becoming a mainstream investment tool of the 1990s.


Securitization is the process of creating securities in public or private markets based on an individual mortgage, pool of mortgages, or properties. Key to a successful securitization are 1) understanding the characteristics of the underlying real estate; 2) mitigating risk to the investor so that an investment-grade rating can be obtained; and 3) accomplishing each of these objectives in a cost-efficient manner.

Review asset type

The securitization process begins with a determination of which real estate--backed assets within a given portfolio are securitizable. Performing residential mortgages have historically been the most common, beginning with single-family-backed mortgage portfolios, which are particularly attractive to investors because of borrowers' strong payment record. Even in a recession, families rarely jeopardize ownership of their homes. Cash flows from a single-family mortgage portfolio thus can be predicted with relative assurance. While most securitizations to date have been secured by performing single- and multifamily residential mortgages, real estate professionals are exploring the securitization of retail, office, and industrial portfolios. Clearly the commercial-backed mortgage market has great potential.

Some underperforming loans may be included in the securitization process. This offers issuers several advantages. In the case of a real estate loan that has been classified as underperforming, for example, banks are often forced to manage and monitor the property, which is frequently an expensive process. Once a bank has recognized a bad loan, it faces the cost of carrying the loan on its books, the legal and consulting expenses associated with workouts, the funding of maintenance costs of ownership, and the expensive mark-to-market adjustments required by generally accepted accounting principles.

As investors become more familiar with the risks and rewards associated with investing in securities backed by commercial real estate and the commercial real estate market recovers, portfolios available for securitization will become more diversified, eventually even including vacant land and real estate owned (REO) or foreclosed real estate.

Due diligence

The next step is to collect as much relevant data about the loans and underlying real estate as possible. This includes financial statements; loan origination documentation, including borrower information; and independently determined current value estimates. One frequently encountered difficulty associated with securitizing Resolution Trust Corporation (RTC) assets is the lack of loan payment documentation. Several recent securitizations were documented using current data for approximately two-thirds of the pool, with original underwriting information available only for the remaining one-third. For commercial real estate portfolios, the single most important factor is debt service coverage.


In light of the current negative perception of real estate, it is imperative that a credible valuation be attempted. Large pools of mortgages cannot be valued individually in a timely and cost-efficient manner. At the opposite extreme, however, these pools cannot be credibly or accurately valued as a single unit. This creates a valuation problem.

Databases may be used to ascertain and document trends and cycles in real estate markets across the country that have evolved over the past decade. Certain well-documented databases can also be used to identify comparable properties, establish a supply and demand model, and estimate market rents. Documenting specific leasing activity at the subject property is preferable to using rent comparables; actual expense histories, in dollars, are more desirable than ratios. Appraisers using a database supplemented by their knowledge of real estate operations and valuation can develop estimates of portfolio level cash flow--ultimately needed to determine debt service coverage. For some portfolio securitizations, particularly those in which a single asset accounts for a significant percentage of value, full narrative appraisals are required.


Obtaining a portfolio rating from an accredited rating agency such as Standard & Poor's or Moody's is the fourth step of the securitization process. According to Standard & Poor's, one of the leading credit rating agencies, "A corporate or municipal debt rating is a current assessment of the creditworthiness of an obligor with respect to a specific obligation."[1] The more indepth, credible, logical, and well documented the previous analysis is, the easier and more cost efficient the rating process will become. In this age of information, well-supported facts and figures are more highly prized by investors and rating agencies than the individual credentials of an organization's inhouse real estate team. Rating agencies first value a portfolio on an "as is" basis, based on the characteristics enumerated in Table 1.

For example, an asset with a loan-to-value ratio of less than 65% and debt service coverage greater than 1.35 times, might qualify for an A rating, while an unanchored shopping center with less than 25,000 square feet of gross leasable area (GLA) and poor owner/tenant credit would receive a lesser rating.

According to commercial bank regulations issued by the Comptroller of the Currency, bonds rated in the top four categories, which are commonly known as investment grades (AAA, AA, A, and BBB by Standard & Poor's or Aaa, Aa, A, and Baa by Moody's), are eligible for bank investment. Various states also impose certain minimum rating requirements on investments by savings banks, trust companies, and insurance companies. As a result, an investment-grade rating is usually required to assure institutional buyers of the marketability of the offering.
TABLE 1 Sample Rating-Agency
Property Mortgage

Characteristics Characteristics

AAA-rated debt carries the highest rating, with the capacity to pay interest and principal seen as extremely strong. While debt that is rated AA differs from the highest rated issues only slightly, debt rated A is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions. Debt rated BBB is thought to have adequate capacity to pay interest and principal. Adverse economic conditions or changing circumstances, however, are more likely to lead to a weakened capacity to repay debt in this category than in the higher rated categories. Each of the credit-rating agencies evaluates the risk of default by examining similar criteria in an effort to determine debt service coverage and loan-to-value ratios.

To obtain the requisite investment-grade rating, the economic attractiveness of a portfolio must be enhanced. This is usually accomplished in one of two ways: by using a credit enhancement provider, or by restructuring and prioritizing debt service payments into tranches or senior/subordinate structures.

The objective of credit enhancement is to ensure that investors receive timely payment of interest and principal in the event the underlying collateral suffers substantial delinquencies or losses. Senior/ subordinate structures typically consist of a rated senior interest and an unrated junior interest in the mortgage collateral. These structures typically prevent junior certificate holders from receiving interest and principal payments until investors in the senior tranche have been paid in full. These risks absorbed by the junior investors reduce payment risk for senior certificate holders. Credit enhancement may also be provided in the form of excess collateral such as a letter of credit provided by a third party. Table 2 illustrates in hypothetical terms the amount of credit enhancement required to achieve an AA rating.

The senior/subordinate structure alone does not provide a source of liquidity in the event that a large amount of mortgage payments is interrupted during a workout/foreclosure period. To compensate for the lack of liquidity, rating agencies frequently require additional servicer liquidity in the form of cash or a letter of credit. Senior certificate holders may suffer shortfalls if delinquencies or losses are in excess of the junior interests and the required liquidity reserve.

The rating process includes a cash flow "stress test," applied on a property-specific basis to all properties in a small pool, or to a sample of properties in a large pool. The following items are among those that may be addressed.[2]

1. Market-rent inflation or deflation rate, applied to all revenue items

2. Landlord's expense inflation rate applied to all expense categories including capital costs

3. Property lease rollover and vacancy assumptions

4. Mortgage interest rates (variable rates only)

Two cash-flow scenarios, a "best estimate" and a stress test, are projected for each asset. In the first scenario, the rating agency estimates the most likely outcome over a ten-year period. Variables 1 through 4 are incorporated into a cash-flow model along with basic lease and property inputs. The first scenario serves to cross-check the validity of information supplied to the rating agency and as a comparison for the stress scenario. The stress scenario subjects each property to a market-rent inflation or deflation rate more conservative than actual market projections. Expense levels are increased to levels above those projected in the best estimate scenario.


After a portfolio has been rated, the issue is typically marketed by an investment bank to institutional bond investors who like the security of an investment grade-rated investment, yet want the increased yield that a real estate-backed issue offers over comparably rated corporate bonds.

In the case of the RTC, the underwriting group consists of Bear Stearns, First Boston, Goldman Sachs, Kidder Peabody, Lehman Brothers, Merrill Lynch, and Salomon Brothers. These are the seven largest U.S. underwriters of mortgage-backed securities, each of whom has committed to the RTC that it will make a market in its securities. Although the RTC is a federal agency, there is no explicit or implicit government guarantee for their securities. The senior tranches of all RTC mortgage securities are required by law to carry an AAA or AA rating. [TABULAR DATA OMITTED]

Financial institutions may continue to service securitized loans to earn associated fees. This has generally been the practice of healthy banks, which have sold portions of their loan portfolios to investors who have chosen to securitize the portfolios. In the cases of failed institutions that are subsequently taken over by the RTC, loan servicing is typically administered by an independent master servicer, such as GE Asset Management Corporation or Equitable Real Estate Investment Management, Inc.


While securitization of commercial real estate has not yet become commonplace, in part because a uniform structure is lacking, one property type has been routinely underwritten. Multifamily mortgage loans represent a large, fairly homogeneous segment of collateral than can be easily securitized. Because the thrift industry originated most multifamily mortgages during the 1980s, these institutions remain a rich source of future securitized financings. As many of these loans mature in the 1990s, there will be an ongoing need for capital to refinance these loans.

Currently less than 10% of conventional multifamily mortgages have been converted to security form through government agencies such as the Federal National Mortgage Association (Fannie Mae), Government National Mortgage Association (GNMA), and the Federal Home Loan Mortgage Corporation (Freddie Mac). The expected increase in securitization will be driven primarily by the reduced presence of the thrift industry as well as by increasing acceptance of real estate-backed securities by institutional investors.

Other factors expected to lead to rising securitization include the lack of capital from other traditional real estate lender; lenders' needs to refinance existing portfolios; the necessity for financial institutions to either reduce their real estate holdings or to convert them into less risky, more liquid assets; and the RTC's mandate to liquidate its portfolio.

Although there have been many commercial property securitizations, ranging from Motel Six in 1986 to Saks Fifth Avenue and Wal-Mart in 1991, the most recent activity has been motivated by the requirements imposed on the RTC by the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) to resolve insolvent thrift cases and dispose of those institutions' assets in an expeditious manner.

The RTC issued approximately $2.7 billion of multifamily-backed securities in 1991; each of the seven transactions received broad investor interest and acceptance. The real estate collateral consisted of performing and underperforming first mortgages (generally no more than two months delinquent) secured by multifamily properties with five or more units. These transactions are summarized in Table 3. [TABULAR DATA OMITTED]

In February 1992, the RTC sold its first commercial property -- backed securitization. Clearly, the RTC prefers the bulk sale approach as opposed to sales of individual assets to investors. There is concern, however, that with institutions becoming the dominant buyers of RTC assets, individuals who want to invest are being excluded from participation. Fortunately, another type of securitization exists--real estate investment trusts (REITs).


According to The Dictionary of Real Estate Appraisal, second edition, an REIT is "a financial vehicle that allows small investors to combine their funds and protects them from the double taxation that is levied against an ordinary corporation or trust; designed to facilitate investment in real estate as a mutual fund facilitates investment in securities."[3]

Traditionally, an REIT has been considered a fairly stable form of real estate investment as well as a source of constant income, although investment performance in the 1970s and 1980s was not always as predicted. The requirement that an REIT distribute 95% of its income in the form of dividends provides investors with yearly cash returns on their investments. The dividend also serves to stabilize the stock price. For example, if an REIT trades for $100 per share and pays a $5-per-share annual dividend, each share of stock yields 5%. If the share price falls to $50, the same $5 dividend would then yield 10%. As the stock price falls, and the yield increases, more investors become attracted to the stock, stabilizing the price.

The REIT structure is not appropriate for every company. Typically, a successful public REIT portfolio comprises neighborhood shopping centers with strong anchor tenants and steady growth; Wall Street does not like surprises, particularly the negative kind. Multifamily properties also offer great potential for the REIT vehicle. The relatively secure cash flow from this type of property mixes well with the distribution requirements of an REIT.

Even in the current depressed real estate and recessionary environment, equity investors have slowly restored the confidence once lost in REITs. In November 1991, Kimco Realty raised $128 million in the first initial public offering of an REIT underwritten by Wall Street in three years. Significantly, 40% of the offering was sold to institutional investors. For 1991, total returns on REITs (35.7%) outperformed the Standard & Poor's 500 (30.4%).[4] The RTC is now exploring the REIT vehicle as a means of offering assets to individual investors.


Few, if any, financial institutions can claim to be unaffected by the current liquidity crunch. To provide liquidity, new financing ideas for all types of real estate assets must be tested in the market, and securitization thus will continue to be an important financing tool in the 1990s. It has already been successfully used to liquify balance sheets, create a market for real estate, and improve capital ratios; these trends can be expected to continue.

Wall Street can be expected to continue to play a growing role in structuring transactions that involve commercial mortgage assets. The RTC holds approximately $40 billion in commercial loans; pooled securities command a better price than loans sold separately and can be disposed of more quickly. Insurance companies are a potential large source of securitizable real estate. Foreign investors are becoming increasingly interested in investing. As securitization is ultimately based on the performance of the underlying real estate, those with particular skills in the process of securitization, including appraisers, will be key participants in the evolution of this new niche in the investment market as it expands into other forms of real estate.

[1.] "Multifamily Mortgage Securitization to Rise," Standard & Poor's Special Report (October 1991): 11.

[2.] Duff & Phelps, Inc., Rating of Commercial Real Estate Securities (undated): 9.

[3.] American Inst. of Real Estate Appraisers, The Dictionary of Real Estate Appraisal 2d ed.

[4.] Salomon Brothers, "An Overview of Real Estate Investment Trusts" (February 6, 1992): 4.
COPYRIGHT 1992 The Appraisal Institute
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Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Author:Gelbtuch, Howard C.; Lipkin, Pamela
Publication:Appraisal Journal
Date:Jul 1, 1992
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